Karen Bardsley was the hero at Bramall Lane, saving two spot-kicks, after the two sides had been deadlocked after 120 minutes with a goalless draw.
Janine Beckie stepped up to despatch the winning strike, having earlier struck the crossbar twice in normal time, in yet another closely-fought contest against the Gunners.
The first of two League Cup Finals for City this weekend, the clash heralded the third Continental Cup Final meeting between City and Arsenal with both sides registering a win apiece in 2014 and 2018.
Each of those triumphs had been clinched with a 1-0 victory so this one was predicted to be an equally-edgy encounter.
As expected, the first half proved a cagey affair of few chances, with both sides tentative in attack.
The game’s first chance fell to the Gunners, as Steph Houghton’s headed clearance fell only to Katie McCabe, who fired to the near post but skewed over.
At the other end, City struggled to create opportunities, with Georgia Stanway mustering the Blues’ first half-chance, uncharacteristically smashing over the bar from range.
Arsenal gained a foothold around the 20-minute mark and almost opened the scoring, when Danielle Van De Donk’s cross was almost deflected into her own net by Houghton. Janni Arnth then headed the resulting corner over the bar.
Heeding the warning, City rallied, mounting pressure of our own as Nikita Parris attempted a looping half-volley, which Arsenal keeper Sari Van Veenendaal just about had covered, before Caroline Weir's effort curled off-target.
The best chance of the opening 45 arrived on the brink of half-time, as Houghton rose to head goalward from a corner. Parris could not convert in the six-yard box and the ball fell to Gemma Bonner at the backpost, who somehow flicked wide.
The game sparked into life after the break and City were unlucky not to break the deadlock on the hour mark, as Parris beat Van Veenendaal to Weir’s pinpoint delivery but watched her header crash back off the crossbar.
With both sides pressing for a winner, it was end-to-end action and Arsenal perhaps should have scored on the break, but for Beth Mead side-footing wide.
The Gunners then introduced top scorer Vivianne Miedema from the bench but it was City who looked the more likely to break the deadlock.
With less than ten minutes left on the clock, Van Veenendaal produced a fine stop to deny Weir, who had been played through well by substitute Beckie, diving at the Scot’s feet to deflect the effort wide.
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Bardsley was then called into action to thwart Mead at the near post on another Gunners’ counter, while Jill Scott forced Van Veedendaal into a flying stop, as the pressure intensified in the dying moments.
Miedema sent Bardsley scrambling in injury time with a sweetly-struck half-volley, before Beckie unleashed a rocket which once again struck the woodwork and ricocheted clear in a thrilling end to the 90 minutes.
Cue extra-time and a tense 30 minutes unfolded.
Parris tested Van Veenendaal once more, latching onto Demi Stokes’ through-ball but poking straight at the Gunners’ shot-stopper.
Lauren Hemp then went close twice from two excellent Bonner and Stanway crosses, and Beckie tried her luck again with a long-range strike, which skimmed the roof of the net.
Deadlocked after 120 minutes of play, the tie went to a penalty shoot-out for the first time in the competition’s history.
Stanway and Kim Little were successful from the spot, but Lauren Hemp saw her effort well-saved.
Bardsley however would not be outdone, thwarting Leah Williamson and Danielle Van De Donk in consecutive penalties – either side of a successful Claire Emslie attempt.
Skipper Houghton then converted – as did Dominique Bloodwoorth, leaving Beckie with the chance to clinch the tie – and she did so with aplomb.
How we lined up…
Nick Cushing fielded an unchanged starting XI from the one that defeated Chelsea in the semi-finals.
Bardsley took her place between the sticks, shielded by a backline of Stokes, Jen Beattie, captain Houghton and Bonner.
Player of the Match…
Weir produced a tireless display and provided City’s best attacking threat with several dangerous set-pieces.
What it means…
City win our third Conti Cup and our fifth piece of major silverware in five years.
The squad depart for the international break, returning to domestic action on Wednesday 13 March with a trip to Reading in the FA Women’s Super League.
Now it's over to the men in Sunday’s League Cup clash…